There’s a growing sense among some leaders that municipal bankruptcy — unthinkable just a few years ago — may be a valuable tool.

Dan Keen knew what he was getting into. When he took the post of city manager of Vallejo, Calif., more than a year ago, Keen understood that Vallejo, a city of more than 100,000 people about 30 miles north of San Francisco, had just emerged from a grueling three-year bankruptcy case. The working-class port town had become the largest municipality to file for bankruptcy after it ran out of money in May 2008. Unable to pay its bills, Vallejo faced a $16 million deficit amid falling property tax revenue and soaring costs in employee compensation and pensions.

So when Keen arrived in Vallejo, he fully expected plenty of headaches. But it was the little things that got him.

“When I came here, the copy machine was on the fritz,” Keen says. “As opposed to leasing a new copy machine, which you would do in other cities, that’s not an option in Vallejo because they’re not going to lease to you. You’re a bankrupt city.”

Many fiscal observers point to Vallejo as Exhibit A of why municipal bankruptcies are a bad idea. The city’s credit rating plummeted, all but killing its borrowing ability. Cuts to services and public safety led to increased crime and prostitution. Even now, the city faces a looming collective bargaining battle with labor unions, and its 2013 budget draws several million dollars from rainy day reserves.

But the landscape may be changing. Since Vallejo, other cities have used bankruptcy filings to help restructure burdensome debts, overhaul pension obligations and renegotiate labor contracts. A handful of California cities are now using bankruptcy to take on that state’s goliath pension system; the outcomes of those cases could spread far beyond California, changing the way other municipalities view bankruptcy. Filing for Chapter 9 will almost certainly remain a decision of last resort, but the stigma may not be what it once was. There’s a growing sense among some leaders that municipal bankruptcy — unthinkable just a few years ago — may be a valuable tool in a city’s financial toolbox.

A big part of the shift has to do with pensions. Employee pensions and other retiree benefits aren’t the only cause of municipal distress, but they’re a major factor. Cities’ obligations to retired employees are gobbling up a larger and larger share of local budgets. In San Jose, Calif., for example, the city’s pension payments jumped from $73 million in 2001 to $245 million in 2012, roughly 27 percent of that city’s general fund budget. But tinkering with those obligations can be next to impossible. Fiscally distressed cities have sought relief by raising taxes and cutting services, but they often hit a brick wall when it comes to contract adjustments. And even in cases where they can negotiate a new labor agreement, existing pension agreements have legally been untouchable.

That was until Central Falls, R.I., declared bankruptcy. The finance-strapped town of 20,000 people, located on the northern outskirts of Providence, had been trying to renegotiate its pension contracts for months with no success. When it filed for bankruptcy protection in August 2011, the slate was essentially wiped clean. The city immediately moved to change its labor and retiree agreements. The new deal hammered out by Central Falls and the unions was essentially what the city had wanted all along, says Ted Orson, the attorney for the city’s receiver. The final agreement slashed pensions by 55 percent (although funding from the state’s general assembly reduced that cut to 25 percent for the first five years).

The difference, Olson says, is that Central Falls was the first city to use bankruptcy to make good on its promise to cut pension benefits. “Up until Central Falls, there was never what we call an ‘or else,’” Orson says. “There wasn’t any leverage to make concessions. However, after Central Falls, when [the labor unions] saw what happened, they understood it’s better to negotiate a better agreement than to be in a position where something can be forced on you and you might not like what it is.”

Central Falls showed cities that pensions were touchable. Now, two cases in California could cement that idea into law. In Stockton, which filed for bankruptcy in June, the city’s bond insurer, Assured Guaranty, is challenging Stockton’s Chapter 9 status because the city did not attempt to renegotiate its pension debt with the California Public Employees’ Retirement System (CalPERS). In Southern California, San Bernardino is arguing that CalPERS should be treated like any other of the city’s creditors. The pension system, says San Bernardino (which surpassed Vallejo last July to become the largest U.S. city ever to declare bankruptcy), should take a haircut right alongside the city’s bondholders and other shareholders. If a judge rules that pension systems can indeed be treated like other creditors — many expect the case to make its way to the U.S. Supreme Court — it could forever change the notion of municipal bankruptcy and fiscal restructuring.

The whole definition of bankruptcy is rapidly changing, says University of Pennsylvania law professor David Skeel. “Each new significant bankruptcy has suggested that a type of obligation that more or less seemed to be off the table is on the table.”

Needless to say, labor unions don’t see the issue the same way. Steve Kreisberg, collective bargaining director for the American Federation of State, County and Municipal Employees, says it’s erroneous to think that the country is entering some new phase when it comes to municipal bankruptcies. He rejects the notion that bankruptcy will be used as a tool for restructuring pensions and similar agreements. Case law, he says, still favors his side. “I really think this idea that somehow we’re going to create a precedent in this country that public employee pensions are a debt like any other is misguided,” Kreisberg says. “So that’s why we’re opposed to giving up anything that’s accrued in terms of a benefit.”

Kreisberg may be right. After all, only about half the states even allow cities to file for bankruptcy. Of the 13 cities, towns or counties that have filed since 2008, five cases have been dismissed by a court. And many of the rest of the filings tend to arise from special cases. In Westfall Township, Pa., for example, the city had been hit by a $20 million federal judgment granted to a developer. And Jefferson County, Ala., had filed because of a failed sewer project and corrupt financial dealings by local politicians.

Nonetheless, many legal observers think the outcome of the cases in California could open the door to a host of new bankruptcy filings. “I think you’ll see cities looking at Chapter 9 as not some horrible thing, but as a business tool,” says San Francisco-based bankruptcy lawyer Karol Denniston, who has helped numerous California cities restructure their finances. She adds that insurers would favor the move because restructuring is not being done “on the back of the bonds.” “I think capital markets would be more receptive if there’s that opportunity to restructure.”

On the other hand, there’s the possibility that such a ruling could actually reduce the number of future bankruptcies. If pensions are indeed deemed to be creditors, labor unions and retirees may be more willing to negotiate in the first place because they know cities’ threats are real — the “or else” that was demonstrated in Central Falls. “I think increasingly you’ll see unions come around if they believe the city or town will qualify [for bankruptcy],” says Robert Flanders, who was the state-appointed receiver for Central Falls. “Because if it does qualify, unions are going to get taken to the cleaners in bankruptcy.”

Indeed, after Central Falls, Rhode Island Treasurer Gina Raimondo pushed through major pension reform at the state level, reform that included raising the retirement age and adjusting benefits for current employees. Raimondo often used Central Falls in making her case for why the reform was needed.

Although many states underwent some kind of cursory pension reform last year, a few cities followed Rhode Island’s dramatic lead. In California, San Diego and San Jose voters both approved changes to city pensions that targeted retirement age and restructured employee contributions.

Many believe those changes wouldn’t have been possible a few years ago. “I think the lesson from all of this is that in cities across the country, there is a need for them to address their pension and health-care liabilities sooner rather than later,” says Chris Hoene, executive director of the nonprofit California Budget Project. In the past, he says, “there’s always been this thought of, ‘We’re not in crisis mode, we have time to sort out this problem.’”

Seeing other places file for bankruptcy has also raised public awareness about the fiscal burdens cities face. In San Diego, for example, retirement fund payments soared from $43 million in 1999 to $231.2 million in 2012. As residents have become more attuned to those kinds of budget obligations, the public outcry against municipal debt restructuring may have softened somewhat. The city of Pacific Grove, Calif., for instance, recently launched community forums to get input from its citizens on how the city should handle its retiree debt. And, says bankruptcy lawyer Denniston, who is helping the city host the forums, Pacific Grove’s large community of retirees isn’t shying away from the issue of balancing pension costs with the need for public services. “If you can get the conversation out in the open that this is a problem, then you get lots of people talking about solutions,” she says. “They’ve watched what’s happened: Nobody wants to be in the position of San Bernardino. They drove off a cliff.”

Taxpayers are also becoming more aware of the fact that the bankruptcy process, by its nature, excludes them from decision-making. Chapter 9 cases deal with debtors and creditors. Taxpayers take a hit in the form of higher taxes and reduced services, but since they aren’t creditors they don’t have a seat at the table, says Skeel, the law professor. “The bankruptcy process isn’t really designed to maximize their voice.”

Perhaps the most important bottom line when it comes to bankruptcy is image.

In Vallejo, the bankruptcy process has bruised the city’s ego as well as its morale, says Keen, the city manager. “You see it everywhere — the pace of work by employees, the police response time. We are not capable of providing what this community needs.”

There’s definitely still a dark cloud associated with bankruptcy, says Lou Schimmel, the state-appointed emergency manager in Pontiac, Mich. (which has not filed for bankruptcy). Bankruptcies restructure debt, but they don’t address gross mismanagement, he says. During his 18-month tenure, Schimmel has struck new labor agreements, consolidated city resources, cut spending and sold off assets to bring Pontiac into a balanced budget. Bankruptcy, he says, doesn’t stop a city from making poor financial choices in the future.

Still, many experts say more municipal bankruptcies are inevitably on the horizon. Hoene, for instance, notes that many cities in the Midwest and the Rust Belt have struggled for years, and some are likely too far gone to avoid bankruptcy. And Michigan recently passed a revised emergency manager law that could ease the restrictions allowing that state’s cities to file for bankruptcy. Perhaps perversely, declaring bankruptcy could ultimately help a city’s credit rating. That was the reasoning in Central Falls, where the bankruptcy court judge’s focus was the city’s credit standing and access to capital markets. If more places begin to see bankruptcy as a restructuring tool for pension obligations — and a route to better credit — the practice could become more common.

“The biggest hurdle,” says Central Falls’ Flanders, “is the stigma that’s still associated with the ‘B’ word. Cities, towns and legislatures are deathly afraid of what that word means.” If the process had another name, Flanders has said, cities would be much likelier to use it. It’s still a very difficult choice to make, and he says he wouldn’t want to recommend it. Still, as he said at a Governing event last fall, “Bankruptcy is not the disease for these cities and towns. It’s the cure.”

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